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Indexes Don't Maximize High-Yield Bonds

Alex Bryan, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have been gravitating to ETFs and other passively managed products. But should they index the high-yield space? Joining me to discuss that question is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's discuss some of the headwinds for indexing high-yield bonds. What are some things that could work against investors even though they want to capture the low costs that often accompany index products and ETFs?

Bryan: Sure. So, high-yield bonds for the most part are fairly illiquid securities. So, they don't trade very often and that can make them expensive to trade when you do want to trade them. So, they tend to have very wide bid-ask spreads and when you want to trade a large amount of fixed-income securities in the high-yield space, oftentimes that moves the market. So, that's a big challenge with an index-based product because indexes demand liquidity. Anytime a security comes in or out of the index, the managers who are trying to track the index have to transact in that security regardless of the price that they get when they execute. So, that illiquidity presents a big challenge.

In addition to that, most high-yield bond indexes out there are market-cap weighted which skews them toward the more liquid issues in that market. It's still illiquid but it's capturing the more liquid aspect of the market. But that truly isn't representative of what active managers in the space are doing. So, the index may not provide a good replication of what active managers are doing in the space. And then thirdly, the cost advantage of index funds in the high-yield bond segment is not as large as it is in the equities segment because most broad beta funds are a bit more expensive there.

Benz: OK. Let's talk about some of the steps that some of the major high-yield indexes take to mitigate some of the disadvantages that you just outlined. Do indexes try to mitigate some of the liquidity issues, for example?

Bryan: Sure. So, the two biggest ETFs out there that are market-cap weighted in the high-yield bond space, it's the SPDR Bloomberg Barclays High Yield Bond ETF, ticker is JNK; and then iShares iBoxx High Yield Corporate Bond ETF, ticker is HYG. Now, both of those funds try to stick to the most liquid issues in the market. So, for example, JNK requires each issue that it invests in to have at least $500 million in par value. It has to have been issued in the last five years, and it has to be among the issuer's three largest bonds. Similarly, HYG has very similar liquidity requirements.

So, that tries to make it easier to gain access to those securities so that the index is more investable and that when securities come in and out of the index, the cost of trading is not prohibitively high. They then weight their holdings by market capitalization which skews the portfolio toward the most liquid securities even to a greater extent.

Now, the problem with that as I alluded to earlier is that the most liquid segment of the bond market is not truly representative of the entire opportunity set. So, active managers in the space, for example, have a bit more latitude to find opportunities among some of the smaller issues out there.

Benz: OK. I want to drill into that thesis in a second. But first, let's just take a look at the performance of these two major high-yield ETFs, SPDR Bloomberg Barclays High Yield ETF and the iShares iBoxx High Yield Corporate Bond ETF. Let's start with JNK, which is the SPDR product. That fund it sounds like has had a little bit of an issue with tracking error.

Bryan: It has.

Benz: And let's talk about what tracking means before we go any further.

Bryan: Sure. So, tracking error is any deviation between the index and the fund that's tracking it. So, ideally, you would like that to be as low as possible. In the fixed-income space, particularly the high-yield fixed-income space, we would expect a higher degree of tracking error than we would in the equity market just because you have to use representative sampling to get exposure to the index to a greater extent than in the equity markets and the transaction cost is a bit higher in the fixed-income space. So, the SPDR product, JNK, as you mentioned, has had a harder time tracking its index than its peer HYG. 

A big part of that reason is due to differences in how the indexes are constructed or how they are calculated more specifically. So, JNK's index prices all of the bonds in the index at the bid price which is the lower price--it's typically the price at which you would sell a security if you wanted to sell it. But the problem is the bond itself when it goes to transacting those securities, it has to add new securities at the ask, which is higher than the bid. So, anytime the managers are going out there to buy new bonds that are added to the index, they are incurring the ask price whereas the index is being priced at the bid. So, that creates this optical illusion of tracking error just due to this real cost that the manager has faced that's not embedded in the index.

Now, HYG's index by contrast better reflects the realities that the managers face. So, it prices new adds to the index at the ask, which is the price that the managers have to pay, and then it subsequently prices them at the bid. So, that more accurately reflects the realities that the managers face. It doesn't necessarily lead to better fund performance. It just reduces the potential gap between the index and the fund's returns itself. 

So, that's a big part of why JNK has experienced higher tracking error. But that's not the full story. It's still, even after controlling for that has had some issues with tracking. Another reason for that has to do with the way that the managers have historically dealt with creations and redemptions into the fund. So, anytime money comes in or out of the ETF the managers take what's called a creation basket where the authorized participant or market maker will deliver in some bonds into the portfolio and they get shares in the ETF in exchange.

Well, the creation basket was a lot smaller for JNK than it had been for HYG. So, they only historically required 40 bonds to be delivered in. Now, that's only a small subset of the total bonds in the portfolio. So, anytime new money would come in, that would cause the portfolio to deviate a little bit from the index, and that contributed to tracking error. HYG by contrast had a larger creation or redemption basket consisting of about 50 to 100 securities. In order to address some of these issues the managers of JNK have increased the size of that creation basket to, I believe, over 100 securities and maybe closer to 150 now. That seems to have helped with this tracking issue. They also replaced the index fund manager. In order to try to bring in some more expertise that could help them try to reduce the gap between their index and the fund performance.

Benz: OK. So, given some of these idiosyncrasies would you say and you kind of did say already, that you think that investors might be better off buying an active fund, maybe using very low-cost ETFs for other parts of their portfolio. But for this space, this is perhaps a spot where you'd want to use an active fund. Let's talk about that thesis and also talk about, well, what fund would that be.

Bryan: Sure. So, in the high-yield bond space, I think, active management makes a lot of sense for a lot of reasons. One, the liquidity challenges that we've discussed, I think active managers can better manage that risk. They can also delve into less liquid securities that may offer higher returns as compensation for that illiquidity. But I think this is also an area of the market where strong fundamental research can pay off, specifically credit analysis because there's a lot of informational inefficiencies in this market and a lot of investors are just relying on what the credit rating agencies assign. So, if you have a bit of an informational edge, or if you do more thorough research than what the credit rating agencies do, I think, there's an opportunity to pick up a better return as a result.

So, yes, I think active management makes a lot of sense, but costs still matter here and not all active managers are going to pass. But I think one of the funds that I like the most in this space is one that has a lot in common with the best index elsewhere. It's low-cost and it has a low turnover. The fund I'm thinking of is the Vanguard High-Yield Corporate Fund which is managed by--obviously, it's a Vanguard fund, but it's subadvised by Wellington. It's been managed by Michael Hong since 2008. This fund basically tilts away from the riskiest, the lowest credit quality issues in the space. It relies on bottom-up fundamental credit analysis. And the combination of its cost advantage, flexibility, and tilt toward the higher-quality issues within the space has allowed it to generate attractive risk-adjusted performance. It's not necessarily going to lead the pack when low-credit quality issues are doing well. But I think over a full market cycle, it will provide a really attractive risk-reward benefit. This fund currently carries a Morningstar Analyst Rating of Silver.

Benz: OK. Let's discuss more broadly, Alex, the role of high-yield in investors' portfolios. We're in an environment where, even though maybe yields are ticking up a little bit, where are still quite low by historic norms, and a lot investors are gravitating to categories like high-yield, emerging-markets bonds, some of the yieldier categories. Let's talk about how someone should think about a category like this, because you do get some equity-related performance with high-yield bonds.

Bryan: You absolutely do. So, I think, it's important to understand that this space, the high-yield bond category, tends to perform more like a broad stock fund than it does a traditional investment-grade bond fund. I was looking at the correlations this morning. Between the JNK, the SPDR product, and the S&P 500, it was 0.76, which is quite high. It's correlation with the bond market was much lower. So, this is not a replacement for your traditional bond fund. This is more of a replacement for equities. 

And I think it makes sense if you believe that you can find a good active manager in this space, and I think there are certainly some good ones here. I think active management has a greater chance of paying off in this space. So, if you want to diversify away from equities, I think, this may be an area where a different type of fundamental research can really pay off. But the risk that you are taking is more similar to the risk that you'd be taking in stock funds. So, it's really important not to be tempted by that yield, not to replace your traditional bond allocation of high-yield bonds. But if you're thinking about moving into the space, I would take it from the equity allocation rather than bond.

Benz: OK. Alex, good points, good opinions. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.